A 401(k) allows (most) account owners to stash away $20,500 per year (or $27,000 for those age 50 and over), without paying any federal income tax on contributions.1 And with 2017’s Tax Cuts and Jobs Act reducing the top marginal tax rate for just about all tax filers through 2026, this could be a good time to reduce your pre-tax income. So how can high net-worth or affluent women optimize the use of a 401(k)?
Reduce Your Marginal Rate to Open Other Doors
Many affluent women earn too much to contribute to a post-tax Roth IRA. However, because each dollar contributed to a 401(k) can reduce a taxpayer’s adjusted gross income, contributing enough to reduce your top marginal rate can open up other retirement doors, whether this is a direct Roth contribution or a Roth conversion at a lower tax rate.
As an example of this latter opportunity, a single taxpayer who earns $100,000 would have been in the 28 percent bracket before 2018.2 As of 2022, this taxpayer is now in the 24 percent bracket, and if she contributes $19,500 to a 401(k), she can reduce her taxable income to fall into the 22 percent bracket.3 This allows her to convert her prior-year 401(k) or IRA contributions into Roth IRA contributions while paying no more than 22 percent tax.
Not only can qualified Roth contributions be withdrawn at any time, tax-free and without penalty, but they also aren’t subject to required minimum distributions (RMDs) like other retirement plans.4 For example, if you’ve made $50,000 worth of Roth IRA contributions over a ten-year period, you later can withdraw up to $50,000, tax-free, at any time to purchase a new car, send a child to college, pay off a mortgage, or donate to charity.
Investigate Your Roth 401(k) Options
Many 401(k)s offer a Roth option, allowing account holders to stash away up to $20,500 in post-tax retirement contributions for 2021 and 2022.5 Although the Roth 401(k) doesn’t offer the same instant tax savings as a traditional 401(k), and may not make much sense for taxpayers who expect to be in a lower tax bracket during retirement, it can provide a great deal of flexibility for those who may be contemplating early retirement or a later-in-life career change.
Roth 401(k)s are more like traditional 401(k)s (or traditional IRAs) when it comes to making withdrawals. Unlike Roth IRAs, Roth 401(k)s don’t allow account holders to withdraw their contributions early, and Roth 401(k) accounts are also subject to required minimum distributions. However, Roth 401(k)s can still be a tax boon for anyone who thinks their future income (and tax rate) is likely to increase.
Evaluate Your Draw-down Order
When you’re getting closer to retirement, the operative question becomes not “how much money do I need?” but “which accounts should I withdraw my money from?” Not only do the various retirement accounts have different tax treatments, but they also have different withdrawal requirements—exhausting your tax-free options like the Roth early in retirement can mean even higher required minimum distributions from your 401(k) after age 70, significantly increasing the total tax you pay on your retirement funds.
This exact dilemma is why we created the Retirement Tax Filter®, our proprietary tool that’s goal is to minimize taxes by evaluating your:
- Retirement Accounts
- Return of Basis
- Interest & Dividends
- Capital Gain/Loss
- Pension & Social Security
- Earned Income
We work with many of our clients and their CPAs to create a draw-down plan that accounts for the balance, tax treatment, withdrawal restrictions, and likely future tax treatment of each retirement account to assist you in making withdrawals in the most tax-efficient manner. In many cases, this means front-loading one’s 401(k) withdrawals to reduce future RMDs and saving tax-free money for later.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regard to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.